J. Michael Hemmer,
Vice Prersidnet-Law,
Union Pacific Railroad
Washington , D.C.
Reprint with permission from the October, 2003 TRAINS Magazine, Letters to the Editor, p.6.

Larry Kaufman's "Industry Insider" columns contribute greatly to TRAINS magazine's increasingly substantive coverage of railroad business. His latest essay "Railroads Don't Earn the Cost of Capital: So What?", pages 20-21 August Trains, however, understates the economic challenges facing railroads and could lull Trains readers into complacency about the industry's future.

Everyone interested in transportation needs to understand the answer to Larry's rhetorical question "So what?" Here's what:

As a new Union Pacific employee, I watched CEO, Dick Davidson, and President Ike Evans present the company's 2003 goals. They stressed for every employee UP's need to strive for and reach its cost of capital. At UP , the costly of capital is no theoretical regulatory concept; its central to our business strategy. As Kaufman observes, any industry that hopes to remain in business must earn its cost of capital. Railroads aren't there yet, and investment in the industry will decline until we get there. Wall Street analyst, Scott Flower, explained it pungently " the industry is not self sustaining from an economic perspective, but its going out of business more slowly than in the early 1980's and late 1970's."

Examples of continuing disinvestment abound: Several Surface Transportation Board decisions each week shepherd abandonments toward completion. As some shippers complain, they acquire many new cars because railroads cannot justify the investment. By selling and leasing light density lines , class 1 railroads defer, but do not solve the problem of inadequate revenues. Many short line do not earn sufficient revenue to justify replacement. Unless the government helps them, watch for more abandonments.

Kaufman quotes a railroader who is apparently content to watch railroads shrink: "We always seem to be able to get the funding we need for our capital-spending program." But those capital spending programs are inadequate to sustain the industry. Union Pacific would spend several hundred million more each year on infrastructure and equipment, but it cannot because of inadequate capital. Accordingly we must set our hurdle rate for investment very high, bypassing investments that would pay off if we could afford them.

Yes Wall Street continues to invest in railroads. It's betting on the future. Flower says: "Simply put, the market expects that railroad industry to eventually earn and exceed its cost of capital." The Street also invests because some parts of the national system surely are viable, and it counts on traffic and revenue growth in high-volume corridors. Unless the federal government destroys the industry through regulation, as it almost did twice during the 20th century, the railroads can fund core investments. But this leaves an important question: how big will the remaining viable core be?

Our nation needs railroads more than ever. Even highway planners finally recognize that we cannot pour enough concrete to maintain personal mobility and transportation efficiency. But the railroads cannot fulfill their appropriate role without sufficient revenues...